How best to measure pension adequacy

39 Pages·2013·0.74 MB·English

by  Jane Dickson

How best to measure pension adequacy

Aaron George Grech

Contents
Introduction .................................................................................................................... 1
1. Pension adequacy objectives envisaged by policymakers ....................................... 2
2. Pension adequacy indicators .................................................................................... 4
2.1 Theoretical replacement rates ........................................................................... 5
2.2 Moving beyond theoretical replacement rate measures .................................. 11
2.2.1 Increasing the number of hypothetical cases ............................................... 11
2.2.2 Spending and/or income based measures of adequacy ............................... 13
3. An alternative approach to measure pension adequacy ........................................ 18
Conclusion .................................................................................................................... 29
References .................................................................................................................... 31

CASE/172 Centre for Analysis of Social Exclusion
April 2013 London School of Economics
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 Aaron G Grech

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Editorial note
Aaron George Grech is a visiting research fellow at the LSE’s Centre for Analysis of
Social Exclusion (CASE) and works at the Modelling and Research Office of the
Central Bank of Malta. This paper builds on research he carried out as part of his
doctoral research at CASE between 2006 and 2010, and expands on results presented
in CASEpapers 140 and 161. He would like to thank John Hills for having provided
very helpful comments and suggestions on this research work. The latter also
benefited from the comments of Nicholas Barr. The simulation model APEX, used to
derive pension wealth estimates, was kindly provided by the Directorate for
Employment, Labour and Social Affairs of the Organisation for Economic Co-
operation and Development (OECD). The author is particularly indebted to Edward
Whitehouse and Monika Queisser, for their kind help, advice and support.

The views expressed in this paper are those of the author, and organisations with
which he is affiliated with do not carry any responsibility towards data used and
interpretations made in the paper. The author also takes full responsibility for all
errors and omissions.

Abstract
Though the main benchmark used to assess pension reforms continues to be the
expected resulting fall in future government spending, the impact of policy changes on
pension adequacy is increasingly coming to the fore. As yet, there does not seem to
be a broad consensus in policymaking circles and academic literature on what
constitutes the best measure of pension adequacy. While various indicators have been
developed and utilised, no single measure appears to offer a clear indication of the
extent to which reforms will impact on the achievement of pension system goals.
Many indicators appear ill-suited to study the effective impact of reforms, particularly
those that change the nature of the pension system from defined benefit to defined
contribution.

Existing measures are frequently hard to interpret as they do not have an underlying
benchmark which allows their current or projected value to be assessed as adequate or
inadequate. Currently used pension adequacy indicators tend to be point-in-time
measures which ignore the impact of benefit indexation rules. They also are
unaffected by very important factors, such as changes in the pension age and in life
expectancy. This tends to make existing indicators minimise the impact of systemic
reforms on the poverty alleviation and income replacement functions of pension
systems. The emphasis on assumptions which are very unrepresentative of real-life
labour market conditions also makes current indicators deceptive, particularly in
relation to outcomes for women and those on low incomes.

This paper posits that these defects can be remedied by using adequacy indicators
based on estimates of pension wealth (i.e. the total projected flow of pension benefits
through retirement) calculated using more realistic labour market assumptions. These
measures are used to give a better indication of the effective impact of pension
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reforms enacted since the 1990s in ten major European countries. They suggest that
these reforms have decreased generosity significantly, but that the poverty alleviation
function remains strong in those countries where minimum pensions were improved.
However, moves to link benefits to contributions have raised clear adequacy concerns
for women and for those on low incomes which policymakers should consider and
tackle.

Key words: Social Security and Public Pensions; Retirement; Poverty; Retirement
Policies

JEL number: H55, I38, J26

Corresponding author: Aaron George Grech ([email protected])

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Introduction
In recent decades European governments have embarked on significant pension
reforms meant to ensure system sustainability.1 Since reducing the impact on
future spending levels was frequently the main aim of these reforms, it is not
surprising that many early studies focused just on this aspect.2 However, more
recently, researchers have broadened their analysis beyond fiscal
considerations3 and started to delve into the broader implications of these
policy changes.4

This change in research focus was, in part, inspired by a shift in thinking on
pension reforms in international economic institutions. For instance in the
1990s the World Bank was an all-out proponent of privatisation and
retrenchment5, so much so that a policy review by its Independent Evaluation
Group6 concluded that “Bank involvement in pension reform was often
prompted by concerns about fiscal sustainability. Yet, in doing so, there often
was a neglect of the primary goal of a pension system: to reduce poverty and
provide retirement income within a fiscal constraint”.7 By contrast the Bank’s
present stance is that “pension systems need to provide adequate, affordable,
sustainable, and robust benefits”.8

However, while the standard measure of the fiscal success of a reform –
reduced future spending9 – is well-known, understandable and clear, there is no

1
For an overview of these reforms, see European Commission (2010), OECD (2007)
and Zaidi et al (2006).
2
See for instance, Disney (2000).
3
See, for example, Dekkers et al (2009) and Zaidi & Grech (2007). Grech (2012)
contains an overview of many other such studies.
4
For instance, Forster & Mira D’Ercole (2005) conclude that “changes in the
generosity of public transfers and taxes have played the largest role in shaping
changes in poverty risks among the elderly within individual countries” of the OECD
during the second half of the 1990s.
5
World Bank (1994).
6
The Independent Evaluation Group is an independent unit within the World Bank that
acts as an auditor of the impact of policies advocated by the Bank.
7
The World Bank Independent Evaluation Group (2006). The World Bank’s previous
approach and its insistence on a mandatory fully funded second pillar had been
criticised by a number of renowned economists, such as Kotlikoff (1999), Orszag &
Stiglitz (1999) and Modigliani & Muralidhar (2005).
8
Holzmann & Hinz (2005).
9
A standard example of this approach is Schneider (2009). In it the author argues that
“the larger the decrease in expected spending on public pensions in 2050 between two
base years, the more successful a pension reform the country achieved”.
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similar consensus on how best to measure whether pension entitlements will
remain adequate. The scope of this paper is to review the indicators that have
been proposed and used in the literature, and suggest alternative measures. To
start this discussion, the following section outlines the aims of pension
provision typically envisaged by policymakers. Section 2 describes the main
pension adequacy indicators used in the literature, and their defects. An
alternative set of indicators based on estimates of pension wealth for ten
European countries is then proposed in section 3. Using pension wealth, rather
than the standard pension adequacy indicators, helps address many of the
concerns raised in section 2 – such as the limited ability of existing indicators
to reflect the impact of different benefit indexation rules,10 changes in pension
age and life expectancy and the impact of systemic reforms11 on generosity.
While the empirical results have already been presented in Grech (2010), the
paper sets out more clearly the methodological improvements of this approach
by comparing them with currently used pension adequacy indicators.

1. Pension adequacy objectives envisaged by policymakers
Pension policy differs largely across countries,12 but this has not stopped
international institutions from coming up with adequacy objectives. While in
no way prescriptive, these objectives are given their due consideration by
national policymakers.

The World Bank, for instance, has wielded considerable influence in shaping
pension reforms. Its current stance is that “pension systems need to provide
adequate, affordable, sustainable, and robust benefits”.13 By ‘adequate’ the
Bank intends that “all people regardless of their level or form of economic
activity” have access to benefits “that are sufficient to prevent old-age poverty
on a country-specific absolute level in addition to providing a reliable means to

10
Benefit indexation rules determine how the value of a benefit changes after it is
awarded. For instance, a benefit could be increased in line with inflation over time.
11
In a systemic reform, a scheme’s financing and benefit accrual structure is changed.
In most cases, pension systems are changed from pay-as-you-go defined benefit
(where benefits are determined in relation to an agreed pensionable income, financed
out of current contributions) to defined contribution schemes (where benefits depend
on contributions made, any accrued returns on these contributions and the time to be
spent receiving the benefit), either notional (i.e. benefits are still financed from
current revenues) or funded (i.e. contributions are not immediately spent).
12 Nevertheless, pension provision tends to be uniformly collectively organised. See
Jousten (2007) for some theoretical explanations of why this happens across
countries. Eckstein et al (1985) shows it is potentially welfare improving to have a
compulsory pension scheme.
13
See Holzmann & Hinz (2005).
2
smooth lifetime consumption for the vast majority of the population”.14 The
Bank specifies that “for a typical, full-career worker, an initial target of net-of-
tax income replacement from mandatory systems is likely to be about 40% of
real earnings to maintain subsistence levels of income in retirement”.15 Systems
offering rates above 60% are seen as unaffordable, as the Bank argues that they
would require contribution rates which would be quite detrimental. Adequacy
needs to be guaranteed over time such that “the pension program should be
structured so that the financial situation does not require unannounced future
cuts in benefits, or major and unforeseen transfers from the budget” and
systems should be able to “sustain income-replacement targets in a predictable
manner over the long term…in the face of unforeseen conditions and
circumstances”.16

The International Labour Organisation (ILO) has through the years led
representatives of governments, employers and trade unions to agree on a
number of conventions on pension provision. These conventions aim to
“guarantee protected persons who have reached a certain age the means of a
decent standard of living for the rest of their life” – which is set by Convention
238 as a replacement rate of 45%.17 This needs to be maintained in view of
changes in the cost of living subsequent to retirement. The ILO also argues
that “statutory pension schemes must guarantee adequate benefit levels and
ensure national solidarity”18 and that risks should not be borne solely by the
individual but must be shared among all social agents. Coverage must also
extend to all members of society and there should not be gender inequality in
provisions.19

Since 2001, the European Union (EU) has achieved agreement among Member
States on common objectives on pension policy – the achievement of which is
monitored through the open method of co-ordination (OMC). The latter is a
voluntary process for political cooperation, where progress towards these goals
is measured by monitoring agreed common indicators. EU Member States
prepare national reports, which are then assessed by the Commission and

14
Ibid.
15
Ibid. This is in line with International Labour Office (1952) – the basic convention for
social security benefits.
16
Unfortunately, the same study, Holzmann & Hinz (2005) concludes that “most
existing pension systems, including some of the recently reformed systems, are
unable to deliver on these promises”.
17
See Humblet & Silva (2002).
18
See International Labour Office (2001).
19
Ibid. Gruat (1998) describes further the ILO’s adequacy principles for pension
reform.
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Council and reflected in joint reports.20 In 2012 this culminated in the
Commission preparing a white paper on pension reform.21 The pension
adequacy objective agreed as part of the OMC states that countries should “in
the spirit of solidarity and fairness between and within generations, guarantee
adequate retirement incomes for all and access to pensions which allow people
to maintain, to a reasonable degree, their living standard after retirement”.22
The achievement of this objective is monitored by looking at 4 primary
indicators, namely the at-risk-of-poverty rate of older people, their median
relative income, the aggregate replacement ratio and the change in projected
theoretical replacement ratio over the next 40 years.23 These indicators will be
discussed in the next section. At the outset, it should be noted that the EU has
shied away from adopting a minimum quantified pension adequacy indicators
approach.

2. Pension adequacy indicators
Arriving at a precise definition of pension adequacy and operationalising it into
an indicator has proven to be difficult. Besides the standard conception that
pension adequacy is determined by the degree of poverty alleviation and
consumption smoothing24 a system provides to the current pensioner
generation, intergenerational comparisons of adequacy also play a role,
particularly in the wake of substantial reforms.25 The perceived lack of
effective pension adequacy indicators potentially could distort the pension
reform debate. Some argue that it partly explains the continued predominance
of fiscal considerations. For instance, Eckardt (2005) argues that “as long as no
reliable prospective income indicators exist, which allow one to evaluate the
effect of more structural changes on future benefits, the rather short-term
policy-making process may further favour the principle of financial
sustainability”.

20
See, for example, European Commission (2010).
21
European Commission (2012).
22
See European Commission (2005).
23
See European Commission (2009). Member States also monitor developments in 8
secondary indicators and 1 context indicator.
24
See Barr and Diamond (2006) for a theoretical discussion of the purpose of pension
systems, and Palacios & Sluchynsky (2006) and Caucatt et al (2007) for an outline of
how national pension systems started being set up at the end of the nineteenth
century.
25
Both Draxler & Mortensen (2009) and Abatemarco (2009) argue that adequacy has
three different dimensions – intragenerational and intergenerational redistribution and
lifetime income smoothing, propose separate indices to measure these dimensions
but then fail to apply their frameworks empirically.
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2.1 Theoretical replacement rates
Kolitkoff (1999) argues that pensions “should replace a reasonable fraction of
pre-retirement income, i.e., they should be consistent with lifetime
consumption smoothing”. In fact, most pension adequacy measures concentrate
on how benefits compare with previous income. The most commonly used
measure is the replacement rate. The latter tries to “assess how well older
people can maintain their pre-retirement levels of consumption once they stop
working”.26 The most economically accurate measure would be one comparing
someone’s consumption pre-retirement with that post-retirement. Due to data
unavailability, this is approximated by comparing incomes collected on a
longitudinal basis. Goodin et al (1999), for instance, compute the ‘effective
replacement rate’ of public transfers in Germany, the Netherlands and the US
by finding in national income surveys “those people whose principal source of
income in one year was market income and whose principal source of income
in the next year was public-transfer income” and then “calculate their income
in the second (public-transfer-dependent) year as a proportion of their income
in the first (market-dependent) year”.

However, this direct measure of adequacy has its limitations. First of all, it is a
historical measure – in that one needs to wait until retirement to be able to
assess replacement rates. Secondly, it is an individual measure and thus may
not be representative of the whole population. Thirdly, it is not a prospective
measure and so does not give information on future changes in pension system
rules – replacement rates would reflect rules as they related to that individual.
Fourthly, it is data-intensive and such longitudinal data are not usually
available. Fifthly it has no direct link with poverty as if someone is poor, and
the pension system replaces 100% of income, while the replacement rate would
seem generous, it would still not reduce the risk-of-poverty.27 Finally it is a
single point-in-time indicator, and does not take longevity into account and
how it affects transfers to the individual.

To surmount some of these issues, theoretical replacement rates are frequently
resorted to. The European Commission, as part of the OMC, regularly
publishes estimates of “the level of pension income the first year after
retirement as a percentage of individual earnings at the moment of take-up of
pensions…for an assumed hypothetical worker, who in the so-called ‘base
case’ has a given earnings and career profile (male, earnings of average wage
constant over his fulltime 40 years career, retiring at 65, etc)”.28 The latest
estimates are shown in Table 1. The OECD also publishes theoretical

26
Munnell & Soto (2005).
27
Goodin et al (1999), in fact, do not use the ‘effective replacement rate’ as an
adequacy indicator but as a measure of the extent to which welfare systems promote
stability over an individual’s life course.
28
European Commission (2010).
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replacement rates for a range of hypothetical individuals, but restricts its results
to state pension provision.29 Table 2 compares the OMC estimates with those
made by the OECD for the hypothetical worker on average earnings, to give an
idea of the role of private pensions. OECD estimates suggests that in ten
countries state pensions do not offer the ILO recommended 45% replacement
rate, while 6 countries offer what the World Bank deems unaffordable
replacement rates. Note that the OECD prepares estimates for workers on
different wage levels. This is similar to what is done in the United States,
where the Social Security Trustees Report includes estimates for a number of
stylised wage earners.30

Blondell & Scarpetta (1999) was one of the first studies of cross-country
theoretical replacement rates. However the authors were quick to point out that
“there is no such thing as a single pension replacement rate in any national
retirement scheme”. This because even with the simplest case – flat-rate
universal old-age pensions – the gross replacement rate will still differ for
individuals as it is determined by their previous earnings, while net
replacement rates will be affected by the progressivity of the tax system. In
fact, the estimates in Table 2 clearly show that replacement rates for people on
different levels of wages differ greatly in most countries, while the data in
Table 1 indicate that tax regimes also vary substantially. Table 2 also indicates
that in some countries, the OMC replacement rate indicator is buoyed upwards
substantially by private pensions. In some cases, such as Poland, Slovakia and
the Netherlands, this is due to mandatory or quasi-mandatory private systems.
Here the OMC replacement rates are subject to rate-of-return risk. In some
other cases, there is also a considerable participation risk, as the OMC
replacement rates assume that the average person voluntarily participates in a
private pension scheme. For instance, in Ireland the replacement rate including
private pensions is 47 percentage points higher than that from the mandatory
state pension.

29
See OECD (2011).
30
See Social Security Administration (2012).
6